METHOD 1 – Selling Covered Calls Against Long Stock
We touched on this method in are earlier post. There are many complex option strategies out there. This in one of the simplest but yet the best for long term income generation in my opinion. Why? Because it combines robust fundamental analysis with an option strategy that forces you to take profits. Some investors reading this will not agree with this strategy as it invariably means selling stock at one time or another. However please now revert back to the Walmart example I outlined in an earlier post this year. Holding a stock indefinitely doesn’t make sense if the stock is not performing. Utilizing covered calls forces you to take profits. It is a strategy where you give up upside potential in return for a greater probability of success on the respective trade. Traditionally, investors were recommended to sell these every month but there are ways we can put this strategy on steroids in order to achieve better returns. Let’s go through a few examples to explain.
In the Gilead chart below, we can see that the stock has moved into overbought territory as its momentum indicators ( RSI on a setting of 5) are well above 70. In saying this, the stock despite its strong rally still only has an earnings multiple of 8.25. Gilead’s average earnings multiple over the past 5 years is 20. This could imply that this stock has plenty more upside but when that potential upside takes place is the million dollar question. In these types of scenarios, I believe the prudent approach is to sell covered calls against maybe half of your shares. So if one was holding 600 shares of Gilead, one could sell 2 call options when the stock becomes overvalued which would mean 200 shares would be at risk of eventually being called away. Long term investors may not agree with this approach but here are the advantages of adopting this strategy.
1. You are forcing your portfolio to take profits
In fact, theoretically, the best way to manage this trade over multiple months and quarters would be to sell covered calls all the way back up until Gilead reached its historic average valuation once more. My aim for this setup would be to be totally rid of this stock once its price to earnings reaches 20. Furthermore I would have no problem selling covered calls early in this setup as long as I had another ripe undervalued opportunity to deploy the potential capital that would come off the Gilead trade. Selling covered calls forces you to take profits and gets your portfolio working for you this minute as “theta decay” now works in your favor.
2. Improve returns even more by selling covered calls when implied volatility is high and/or when the stock is overbought
Gilead reported earnings at the the end of July so its implied volatility at present is not elevated. This means the prices of its options are not that expensive compared to their 12 month averages.
Source : Interactive Brokers
You see the four spikes in the chart above? This was when Gilead announced each of its quarterly earnings numbers over the past year. Just before these announcements would have been ripe times to sell covered calls as the call options prices would have been inflated. ( We will go through a pre-earnings example in posts that follow). Just remember to not give up your shares for nickels on the dollar. The time to sell covered calls aggressively is when the stock has high implied volatility and/or when the stock is overbought on a short term basis. The perfect combination of both high implied volatility and overbought conditions may not show up at the same time though so ultimately you will have to make a decision as to which way you want to play this. My preference is to sell covered call contracts in the monthly expiration cycles (30 to 45 days out) as that is where there will be more liquidity.
So presently, Gilead’s RSI momentum indicators are in overbought territory which will be reason enough for many to keep the foot to the floor and keep selling covered calls. Here is the state of play at present. Gilead’s next ex-dividend date is on the 14th of September ( time of writing – 2nd of August – Gild shares at $75.70) The next monthly cycle that will interest us with the cycle ending on the 15th of September. Below is a screenshot of the price of the calls from that given cycle.
Source : Interactive Brokers
With the stock trading at $75.70, the $77.5 call (trading for around $1.10) sticks out as the most obvious strike price to start selling calls on. The next way to supercharge this strategy is to take profits early which we will discuss here
3. Don’t let the call option expire worthless if this are healthy profits to be achieved
This is a crucial step in the management of your portfolio and one that should not be overlooked. For example, after you sell the above mentioned call for $1.10, the stock could easily gap down to the $74 or $73 level ( remember – it is overbought momentum wise) which could easily decrease the value of the call option down to the $0.70-$0.75 level. Personally, I would be taking profits here and here is why. If there is 30 to 35 days left to go to expiration and $0.70 for example is the maximum I can make on this call option, it doesn’t make sense to hold it until expiration. The stock could easily turn around and rally again which would increase the price of the call. Why would I then hold it if I have already made a 30 to 50% paper gain? It just doesn’t make sense. I usually take profits when they get presented and wait for the stock to rally once more so I can sell more calls against my long stock. Rinse, wash, repeat. Yes this strategy requires more management but you are going to make so much more money this way. In that 44 day cycle for example, you could easily sell 5 to 10 different covered call contracts whereas if you only sell one, the maximum you could make is the initial credit received – $110
Now what if Gilead keeps on rallying aggressively and spikes above our initial strike price of $77.50? Well if the price of the shares are above $77.50, then 100 shares per call option will be called away and you will have made full profit on the call option plus the capital gain appreciation of the stock. This is going to happen from time to time. You need to be ready for it. However this doesn’t mean you will never enter into this stock again. Furthermore as long as you have other ripe opportunities, I see no problem in letting your shares go. Remember, covered calls force you to take profits and nobody ever went broke making profits consistently.
The one thing though you have to watch is when your call is in the money ( strike price below the price of the shares) as the buyer of the call will exercise the option to collect a potential dividend. For example, Gilead has just announced a $0.52 quarterly dividend that will go ex-dividend on the 14th of September. Recipients of this dividend will have to be holding shares 2 to 3 days before this date to ensure they will indeed collect this dividend. Therefore our shares could be at risk of being called away early if the call buyer feels he will benefit more by exercising the call option ( which is to take possession of the shares instead of leaving the call option run). Traders ( who don’t usually hold stock) will usually attempt to avoid these circumstances as a naked call exercised would result in the respective trader who is short the call end up being short stock if the option were to be assigned. There are rolling strategies also one could undertake to ensure the collection of the dividend but here is my stance on this. If Gilead was trading well above $77.5 or $80 at expiration, there is a very good chance that call options will be exercised.
Don’t worry about it. Remember the calls are covered. What simply happens is that you transfer your shares over to the call buyer ( which happens automatically) between your brokerage account and his. Remember the shares were going to be called away anyway. Furthermore missing the dividend is not a big deal and here is why. When you tot up what you make from the capital appreciation of the shares plus the call option, the dividend payout will only make a very small percentage of the total profit you made here. I just wanted to mention this in-case you see your shares being called way before the expiration date. Shares will still be called away at the strike price you have sold the covered calls at plus you now have capital freed up earlier to sell more premium against quality dividend growth stocks.